'I Asked Myself: Is This the Big One?'

The Fed chairman was not even impressed by a letter the Mortgage Insurance Companies of America (MICA), a trade association of US mortgage providers, sent to the Fed on Sept. 23, 2005. In the letter, MICA warned that it was "very concerned" about some of the risky lending practices being applied in the US real estate market. The experts even speculated that the Fed might be operating on the basis of incorrect data. Despite a sharp increase in mortgages being approved for low-income borrowers, most banks were reporting to the Fed that they had not lowered their lending standards. According to a study MICA cited entitled "This Powder Keg Is Going to Blow," there was no secondary market for these "nuclear mortgages."

Three days later, Greenspan addressed the annual meeting of the American Bankers Association in Palm Desert, California, via satellite. He conceded that there had been "local excesses" in real estate prices, but assured his audience that "the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices."

The Maestro had spoken -- and the party could continue.

William White and his Basel team were dumbstruck. The central bankers were simply ignoring their warnings. Didn't they understand what they were being told? Or was it that they simply didn't want to understand?

In the March 2006 BIS quarterly report, the Basel analysts described, once again, the grave risks of the subprime market. "Foreign investment in these securities has soared," they wrote. They also cautioned that there were "signs that the US housing market is cooling" and warned that investors "may be exposed to losses in excess of what they had anticipated."

A short time later, White argued for his model once again in a working paper titled "Is Price Stability Enough?" Low inflation rates are not a sign of normalcy, he warned, and central banks should not allow themselves to be led astray by low rates. Both the LTCM bankruptcy and the collapse of the stock markets in 2001 occurred "in an environment of effective price stability."

It was a waste of time and effort. Roger Ferguson, the then-deputy Fed chairman, ironically started to refer to the BIS's Cassandra-like chief economist as "Merry Sunshine."

"There are limits to pressing your argument," White says. "If you keep repeating your point over and over again, nobody will listen anymore."

A Loss of Confidence

Ben Bernanke, who succeeded Greenspan as Fed chief in early 2006, was especially deaf to White's warnings. When he presented his biannual report on the state of the economy to the US Congress on July 19, 2006, he made no mention whatsoever of the subprime risk.

A few months later, in December, the BIS reported that the index for securitized US subprime mortgages had fallen sharply in the fourth quarter of the year. A loss of confidence began to take shape.

The first casualties began surfacing a few weeks later. On Feb. 8, 2007, HSBC, the world's third-largest bank at the time, issued the first profit warning in its history. On April 2, the US mortgage lender New Century Financial filed for bankruptcy.

Bernanke remained unimpressed. "The troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system," he said. It was June 5, 2007.

White made one last, desperate attempt to bring the central bankers to their senses. "Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived," he wrote in June 2007 in the BIS annual report.

But even if Bernanke had listened, it would have been too late by then. On June 22, the US investment bank Bear Stearns announced that it needed $3 billion (2.1 billion) to bail out two of its hedge funds, which had suffered heavy losses during the course of the US real estate crisis. In Germany, entire banks were soon seeking government bailout funds. Banks increasingly lost trust in one another, and the money markets gradually dried up.

It was the beginning of the end. "When the crisis started, I asked myself: Is this the big one?" White recalls. "The answer was: Yes, this is the big one."